The Impact of International Factors on U. S. Inflation: An Empirical Test of the Currency Substitution Hypothesis

Abstract

A common argument for flexible exchange rates is that they insulate the domestic economy from external monetary shocks. Consequently, the domestic rate of inflation and income growth are related directly to the behavior of the domestic money supply. The insular properties of a flexible exchange rate system have been challenged over the past few years by proponents of the theory of currency substitution. Advocates of currency substitution argue that the domestic demand for money is a function of the relative opportunity costs between domestic and foreign holdings of monetary assets. Failing to recognize these international influences yields a domestic money demand function that appears to be highly unstable.' Consequently, depending on the particular set of international forces affecting the domestic demand for money, a given rate of domestic money growth can lead to a variety of rates of domestic inflation.